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Kass: Merits of Market Agnosticism

Doug Kass

This blog post originally appeared on RealMoney Silver on March 25 at 8:45 a.m. EDT.

"The stock market is a no-called-strike game. You don't have to swing at everything; you can wait for your pitch. The problem when you're a money manager is that your fans keep yelling, 'Swing, you bum!'"

-- Warren Buffett, 1999 Berkshire Hathaway Annual Report

I marvel at the conviction and the authority of opinion of the bulls and bears alike these days (actually all days!). But talk is cheap -- especially from the media and those who, regardless of the market's backdrop, inflexibly talk their own book with a degree of confidence that is typically unearned based on past performance.

On The Edge, I attempt, through logic of argument and analytical dissection, to offer my current views on the economy, the market, sectors and on individual securities. (There is no reconstructing history as subscribers can easily see the imperfection of my views through the RealMoney archives.)

I started the year with my underlying concerns being credit and the consumer, and with an expectation that the S&P 500 would drop by 5% to 10% in 2008. By early March, the markets overshot my forecast to the downside.

As most subscribers are aware, I have grown increasingly more constructive into the recent market decline. A week ago Monday, into the teeth of the Bear Stearns (BSC - Cramer's Take - Stockpickr) meltdown, I raised my short-term market rating to 7 (out of 10; 10 being the most bullish and 1 being the most bearish) in my opening missive.

In that piece, I revisited the positives and negatives of my month-earlier column, and I wrote that "when I revisit these factors today, I can see the balance tipping over toward the positive ledger." I further outlined "some weighing (not voting) considerations that could buttress the markets and/or suggest that the current issues could be in the process of being discounted in the markets, forming the basis for the potential for a more constructive view in the days/weeks ahead after the panic subsides."

These included the following:

• The curative and clearing process addressing many of the financial institution's capital issues, has been under way for months.
• We are bottoming, not yet recovering in housing.
• Corporate balance sheets are in great shape and should buttress the current credit issues.
• Sovereign wealth funds remain flush (though relatively uncommitted) and stand ready to commit opportunistically to shore up capital of some of the United States' largest financial institutions.
• The yield curve's steepening could, in the fullness of time, incent banks to take more risks.
• Corporate profit expectations, which were unrealistic until recently, are being pared quickly and are catching up to my downbeat projections.
• Over the last 50 years, job losses (a lagging economic indicator) have coincided with economic stabilization and a positive turn for equities.
• Stocks have declined by 20% within a six-month period for the fourth time in a quarter of a century (1990, 1998, 2000). In the 12-month period following the 1990 and 1998 corrections, stocks rallied by 34% and 39%, respectively.
• As I have noted previously, unlike previous bear markets, equities were not the subject of speculation at the top; commodities, residential and non-residential real estate, and private equity were.
• If corporate profits avoid a major slide in 2008, stocks are inexpensive relative to short- and long-term interest rates. Indeed, with a seeming bubble in the bond market, a broad reallocation of assets out of fixed income and into equities seems possible.
• With the speed and momentum of the credit crisis intensifying coupled with a continued weakening in economic activity (especially of a job kind), the negativity bubble now appears so inflated that it could be ready to pop.

As futures cratered on Monday, I was undaunted and ultimately upped my short-term rating to a near maximum 9 (out of 10), an important statement for me.

In the interim interval, my short-term confidence in the markets has been rewarded with a 5%+ rise from the market's bottom only two weeks ago, and I have moved back to being a market agnostic, with a short term rating of 5 (out of 10).

On one hand, while I believe strongly that we have again successfully retested the low (for the second or third time!), I am not confident that last week's gains can be quickly repeated and that we are off to the bull market races. On the other hand, I can see some light at the end of the bear market's tunnel.

Many will see this view as equivocating -- after all, one always has to have a market view.

Or does one?

When I was a youth, I felt mandated to analyze and predict every market wiggle. But, over the years, I have learned to move only when convicted. (Late March/early April might be such a period in which a more neutral posture is called for.) Besides the general words of wisdom in the Buffett (another greybeard) quote with which I began today's opening missive, The Oracle of Omaha also reminds us that excitement (and transaction costs) are the enemies of investors. And sometimes too many (or too frequent) opinions can be the enemy.

The Beginning of the End (of the Bear Market)

A more bullish case is not hard to make these days. I have made it and so have others on this site and elsewhere.

In a recent lunch, Greg at Mega voiced to me a sound, rigorous logic in his expression of a balanced and more bullish (though not adamant) case. It's good reading in its presentation of logic and in its sense of history.

In summary, the principal and traditional determinants of the U.S. stock market's future course (fundamentals, interest rates, valuation, technicals and sentiment) are all beginning to point to (or have already turned into) positive territory.

• Fundamentals: Economic expectations are subdued and many of my credit-induced concerns are in the generally accepted consensus. Though most corporate profit forecasts are still too optimistic, they are coming down posthaste. Importantly, the process of curing seized-up credit markets and of remedying what ails the world's financial institutions is proceeding rapidly.
• Interest rates: By any measure, equities are inexpensive against interest rates.
• Valuation: Even against a 10% haircut of consensus forecasts for 2008-2009 corporate profits, the U.S. stock market has value.
• Technicals: Stochastics, oversold, put/call activity and other technicals measures are flashing green.
• Sentiment: Overall negative sentiment is perhaps the best reflection of investors' bearishness today, and the negativity bubble has never been as inflated as participants' expectations have fallen to depths unseen in years.

Are all the conditions of a market bottom in place? Of course not, they never are. Or at least it is unlikely that I will be able to "call the bottom."

The current obvious indecision and manic nature of the markets (without memory from day to day) when coupled with near-panic and emotional conditions speak to a bottoming (not topping) action.

Buffett nailed it years ago when he wrote that "most people get interested in stocks when everyone else is. The time to get interested is when no one else is. You can't buy what is popular and do well." As always, timing is the unknown element to the market's riddle, but as legendary technical analyst Walt Deemer once so succinctly exclaimed, "When you should buy, you don't want to."

That time was a week ago.

But Not the Beginning of a Bull Market

"Against this backdrop, what's really perplexing is that Wall Street analysts don't think that a weak 2008 will cast doubt on the vigor of next year's results. On the contrary, in what I think is fundamentally flawed logic, they have maintained the level of their 2009 estimates where they were so that downward revisions to 2008 earnings actually boost the 2009 growth rate. Street estimates for 2009 S&P 500 earnings growth have been revised up to 15.5% from 14.7% at the beginning of January (for details, see "Business Conditions: Bouncing Along the Bottom," Global Economic Forum, March 14, 2008). By comparison, we expect a 5.9% increase in 2009 after-tax economic profits (following a contraction in 2008) that would leave the level below that in 2007."

-- Richard Berner, Morgan Stanley

Just because a bottom has been made doesn't mean that we are off to the races.

My biggest concern is that earnings expectations, which are the key metric in evaluating future stock prices, remain too elevated. (More on this in the next few days.)

As well, the credit markets remain in a sorry state, increasingly decoupled from equities and showing limited improvement. What I now see happening is that, essentially, the banking industry is being forced to extend loans during a credit bear market at bull market prices.

In a sign of last resort during the credit bear, companies -- CIT Group (CIT - Cramer's Take - Stockpickr), for instance -- are being forced to draw down credit lines, often at interest rates that are below market and with associated fees that, too, are below market to the banks. This is occurring at a time in which banks are trying to reduce their balance sheets, and its serving to curtail lending and credit availability elsewhere -- for example, in consumer loans and mortgages. (More on this as well in the next few days.)

In summary, as we move toward the end of 2008's first quarter (and with it the attendant "marking up" of positions) coupled with the current price momentum, I can clearly see some continued market strength.

Nevertheless, given my concerns on the corporate profit and credit fronts, the week of March 24 might be an excellent time to take bets off (long and short) that aren't of high conviction until we see a softball right over the plate.

Doug Kass is the author of The Edge, a blog on RealMoney Silver that features real-time shorting opportunities on the market.

Know What You Own: BSC operates in the financial services industry, and some of the other stocks in its field include Goldman Sachs(GS - Cramer's Take - Stockpickr), Morgan Stanley(MS - Cramer's Take - Stockpickr), Merrill Lynch(MER - Cramer's Take - Stockpickr), Bank of America(BAC - Cramer's Take - Stockpickr) and Lehman Brothers(LEH - Cramer's Take - Stockpickr). These stocks were recently trading at ($180.94, +1.15%), ($49.13, +0.78%), ($48.00, -0.79%), ($40.99, -3.44%) and ($45.21, -3.07%), respectively. For more on the value of knowing what you own, visit TheStreet.com's Investing A-to-Z section.